Discounted Cash Flow Applications

Introduction

In the section we apply time value of money analysis to valuing financial instruments. First of all
we consider internal rates of return and net present value calculations; these provide a critical
input to the decision whether any investment (bond, equity, real estate etc.) is attractive or not.
We also consider alternative measures for calculating portfolio returns and the impact of the choice
of method on the calculation results. Finally we analyze cash flows from short-term money market
instruments and look at the different methods for calculating yields.

Net Present Value (NPV)

NPV differs from present value (PV) in that it takes into account cash outflows. In the context of
valuing an investment this means the present value is adjusted for the cost (cash outflow) of the
investment.

The steps in valuing a project or investment are:

Step 1 Identify all the cash inflows and outflows

Step 2 Identify the appropriate discount rate or opportunity cost of capital

Step 3 Calculate the PV of each cash flow, outflows are negative, inflows are positive

Step 4 Sum all the PVs to arrive at the NPV of the project or investment

Step 5 Apply the NPV rule. If the NPV of a project or investment is positive, it is expected to add to
shareholders' wealth and we should accept the investment, and if it is negative we should reject it.

Where Eq. (1)

CFt =

expected net cash flow at time t

N = investment's life

r = discount rate or opportunity cost of capital

Example 1

A company is considering an investment which will cost $8 million and will generate net cash flows
of $1 million per annum in perpetuity. If the cost of capital is 12% should the investment be
accepted or rejected?

NPV = CF0+CF/r

= -$8,000,000 + ($1,000,000/0.12)

= $333,333

where

CF = the cash flow in perpetuity

Since this is positive the project should be accepted.

Internal Rate of Return

This is the rate of return generated by an investment and it is the rate of return or discount rate
which makes the NPV = 0, using Eq. (1)
NPV = 0 =

or, if we arrange and the investment equals the initial cash flow

Investment =

The assumption is made that cash flows are reinvested at the IRR.

The decision rule is that if the IRR is greater than the opportunity cost of capital (or hurdle rate)
then the investment should be accepted, if less then the investment should be rejected.

The NPV and IRR methods give the same decision for projects which are independent but when a
company is making a choice between different projects, of different sizes or with different timings
of cash flow, the two methods may produce conflicting recommendations. Since the NPV method
uses the market-determined cost of capital, and we are concerned with shareholder wealth, it is
the better measure to use.

It is important to note that if the cash flows could only be reinvested at a rate less than the IRR, or
12.5% in e.g. 2, the actual return realized will be less than the IRR. Similarly if the reinvestment
rates available are higher then the return would be higher.

Example 2:

Using the data in e.g. 1, we need to solve

$8,000,000 = $1,000,000/IRR

IRR = 0.125 or 12.5%

Therefore, if the cost of capital is less than 12.5% then the company should invest, if it is more
than 12.5% they should not invest, and if it is equal, investment will increase the size of the
company but not increase stockholders' wealth.

Measuring Portfolio Returns

Two ways of measuring the return from a portfolio are the money-weighted and time-weighted
rates of return.
1. Money-Weighted Rate of Return

This is the same as the internal rate of return for a portfolio and takes into account the timing and
amount of cash flows in and out of a portfolio.

Example 3: Money-weighted rate of return

An investor purchases a share at $100 and a year later purchases another share at $120. At the
end of the second year he sells both shares at $125 per share. He receives dividends of $5 per
share at the end of each year but does not reinvest the dividends.

PV (outflows) = PV (inflows)

The outflows are the payments for the shares and the inflows are the dividends received and the
proceeds of the sale of the shares. So if r is the internal rate of return or the discount factor used:

Using a financial calculator to solve for r, r = 13.69%

Note - although the portfolio holding period return in the first year was ($120 + $5 - $100)/$100
= 25%, and in the second year was ($250 + $10 - $240)/$240 = 8.33% the money-weighted rate
of return is below the average holding period returns. This is because the portfolio performed less
well in the second year when there was more money invested in the portfolio.

2 Time-Weighted Rate of Return

This is the standard measure of performance in the fund management industry. The returns from
different periods are averaged over time but it requires doing the following for an exact measure:

1. Value the portfolio before any significant addition or withdrawal of funds, look at subperiods
between cash inflows and outflows.

2. Calculate the holding period returns for each subperiod.

3. Compound the holding period returns to obtain the rate of return for the complete year. If
required take the geometric mean of the annual returns to obtain the return over a longer
measurement period.

Example 4: Time-weighted rate of return

Looking at the portfolio returns in e.g. 3 we have calculated the holding period returns to be 25%
and 8.33%. Over the two periods we can calculate the time-weighted rate of return, R, by using

(1 + R)2 =(1.25)(1.0833)

R = 16.37%

This is the return achieved for each $1 invested in the portfolio at the beginning of the period.

Another example should help clarify the different results obtained from using the money-weighted
and time-weighted rates of return.

Example 5: Money and time-weighted rate of return

A new fund was started with a value of $100 million, after 3 months the fund was revalued at
$125 million and another $25 million was raised from investors. At the end of the year the fund
had fallen in value to $140 million.

The money-weighted quarterly rate of return is given by r where

PV (outflows) = PV (inflows)

Solving for r gives r = 3.025%

The annualized money-weighted rate of return is therefore (1.03025)4 -1 = 13.65%

To calculate the time-weighted rate of return we need to calculate the rate of return in the first
quarter and then the subsequent three quarters:

1Q, R = ($125 - $100)/$100 = 25%

2Q-4Q, R = ($140 - $150)/$150 = -6.67%

The annualized time-weighted rate of return is therefore

(1.25)(0.9333) - 1 = 16.66%

This is higher than the money-weighted performance since the money-weighted performance is
dragged down by the negative performance in the second period when there were more funds
invested in the portfolio.
Pure discount instruments are quoted on a bank discount basis, rather than on a price basis,
whereas bonds and other longer-term instruments are quoted on a price basis.
1. Yield on a Bank Discount Basis

The yield on a bank discount basis simply annualizes the discount as a percentage of face value,
based on a 360-day year.

(eq. 2)

where

rBD = annualized yield

D = discount amount

F = face value of the instruments

t = number of days remaining to maturity

360 = convention for the number of days in the year for a bank discount calculation

Example 6: Bank discount yield

A T-bill has a face value of $1,000,000 and 270 days until maturity. What is its bank discount yield
if it is selling at $950,000?

Applying eq. (2):

The bank discount yield does not meaningfully measure the return earned by an investor since a
proper return calculation ought to reflect the return relative to the purchase price and take into
account the reinvestment on a compound basis. Also the bank discount yield is based on a 360
rather than 365 day year.

There are three other commonly used yield measures:

2. Holding Period Yield (HPY)

The holding period yield looks at the return (not annualized) relative to the purchase price.

(eq 3)

where

P0 = initial purchase price

P1 = price at maturity

D1 = interest or dividend income received during the holding period

Example 7: Holding period yield

The holding period yield of the T-bill in e.g. 6 will be:

HPY= (1,000,000 - 950,000 + 0)/950,000 = 5.26%

3. Effective Annual Yield (EAY)

This is the annualized holding period yield (based on 365 days) and takes into account interest
earned on interest.

(e.g. 4)

where

HPY = holding period yield

t = number of days to maturity

Example 8: Effective annual yield

The effective annual yield (EAY) for the T-bill in e.g. 6 will be:

This is higher since the HPY calculation was based on only 270 days.

4. Money Market Yield (MMY), or the CD Equivalent Yield

This is the annualized holding period yield, but this time based on a 360-day year, to make it
comparable with money market instruments that pay interest on this basis.

In many cases we do not know the Treasury bill price so eq. 5 is more useful.

(eq. 5)

where

rBD = bank discount yield

t = number of days to maturity

Example 9: Money market yield

The MMY or CD equivalent yield for the T-bill in e.g. 6 will be:

A convention in bond markets is to double the semiannual yield to arrive at a yield called the
bond-equivalent yield.

Example 10: Bond-equivalent yield

A bond has a semiannual yield of 3%.

The annualized, or effective annual yield is (1.03)2 - 1 = 6.09%

The bond-equivalent yield is simply 3% x 2 = 6 %.